Whole Life or Term Life: Which Insurance Do Young Parents Need?

In this Answers, Answers segment from the episode of Motley Fool Answers, Alison Southwick and Robert Brokamp unravel an issue that confuses many people: What's the difference between term life and whole life insurance, and which is the better choice for your family? Whole life, with its combination of a "permanent" policy and a savings vehicle, can look quite appealing at first. But as Bro explains, when you buy an insurance policy that is also an investment, what you generally get is something that performs neither role well.

A full transcript follows the video.

This video was recorded on Dec. 12, 2017.

Alison Southwick: It's time for Answers, Answers and today's question comes from Ziff, who I believe we have answered a question from before...

Robert Brokamp : Yes.

Southwick: ... but Bro likes this one...

Brokamp: We like good questions.

Southwick: ... so we're going to go for it. Ziff writes, "We are a married couple in our mid-20s with kids on our mind. Should we buy term life insurance and deal with its steep premium increases at renewal time, or should we buy into whole life insurance, which will force us to save money for the future despite its higher management costs?"

Brokamp: Ziff, you're doing the right thing that you're considering getting life insurance once you have kids. That's the time of life to do it. If you don't have kids, and if you're married and your spouse is adequately employed, you probably don't need life insurance. But once you have kids it's definitely time to do it and both spouses should consider getting it, even if only one is working. It's a good time to be thinking about it.

The difference between term and whole life is that term is pure insurance. You just buy it for a certain amount of time known as "a term." You can do it for one year, five years, 10 years, 20 years, 30 years.

Whole life has insurance, but also has a tax-deferred savings component. You can build up a cash value that you can either borrow against or use in retirement. It's a combination of insurance as well as building up your net worth. The problem is it often takes over a decade to build up a significant cash value and people often consider it permanent insurance because you can hold onto it for the rest of your life as long as you pay the premiums. The premiums do stay level, which is nice. Once you sign up for it, and you are told it costs a certain amount, you know you just have to pay that every year.

If you set the term -- let's say you buy 20-year term -- 20 years up you need more life insurance. If you go back to get more, it's going to cost you more.

Southwick: Because you're older.

Brokamp: Because you're older. On paper, whole life always looks better until you look at the cost. Because of the savings component, and because, frankly, there's some other embedded costs in there, it's much more expensive. And it's not just a little bit more expensive. According to an article on NerdWallet, let's say you are a 30-year old male and you want to get $1 million in insurance for a 30-year term, it's going to cost you $720 a year. A $1 million whole life policy is going to cost you $9,200 a year.

It's a huge difference. What people often do when they like the idea of whole, but they can't afford that, [is they'll get a smaller policy]. [They'll] get a $500,000 policy instead of $1 million. But then you're underinsuring yourself. And when you think of a couple in their 20s having kids and maybe buying a house, they're not going to be able to afford that type of premium.

At the outset, or maybe later down the road, what often happens with these whole life policies is that people decide five or 10 years into it, "I can't afford this policy," and then they drop it. They're back to square one at that point. For most people it's best to go with the term at least 20 years or 30 years. What you're really looking at is having enough insurance so that you're covered until your kids are out of the house.

I got a 20-year policy the first time a kid was born. The next time we had a kid I got another 20-year policy. That's how I've done it and I think that's a good way to approach it.

Southwick: I think when we shopped around for life insurance, they said to get a policy for your earning years.

Brokamp: You could do that, and a 30-year will probably cover a lot of that. Once the kids are out of the house [assuming that all along the way you've been saving for your retirement, building your career, and assuming your spouse has a career, too], if the kids are out of the house and taken care of, and one of the spouses passes away [let's say in their mid-50s], the other spouse should still be OK. But some people don't feel that way. They want to have that insurance all the way up until retirement and you can do that. You can get a longer-term policy, but it's going to cost you more.

Southwick: You threw out the numbers $500,000 and $1 million. How do you figure out how much insurance you need?

Brokamp: The rough rule of thumb is 10 times your salary, which is surprisingly good as rules of thumb go. There are plenty of calculators out there on the internet in which you factor in all kinds of things. Whether you want to pay off your mortgage or not. But ten times your salary is pretty good.

Southwick: Gross. Gross salary? Before taxes?

Brokamp: Yes, before taxes. Even though the good thing about life insurance is that it is tax-free, which is nice.